The returns investors tend to earn could be lower than delivered by mutual funds (MFs) they have invested in, states a report Mind the Gap by Morning Star. This trend is prevalent and seen across asset classes, however, it varies from category to category. The difference in returns is attributed to the investors’ behaviour, and it is also referred to as ‘behaviour gap'.
The gap in returns was as high as 2.68 percentage points over the three-year period and 2.5 points over the five-year period, and 5.79 points over the 10-year period, the report says.
The gap could be the result of several reasons, or an interplay of them. These include timing the market, buying (or selling) on the basis of recent performance, chasing after a fad, or just deciding to leave the market when it's temporarily down. All these decisions can be destructive to your portfolio, says the report.
Even in the famous book The Psychology of Money, author Morgan Housel explains that a genius who loses control of their emotions can be a financial disaster. And the reverse is also true. Regular people with no financial education can be wealthy if they have a handful of behavioural skills that have nothing to do with formal measures of intelligence.
He explains, “Your personal experiences with money make up maybe 0.00000000001 percent of what’s happened in the world, but maybe 80 percent of how you think the world works.”
The biases can be of several forms. We try to decode them here:
1. Persistency bias: Under this bias, investors tend to choose a fund based on its past returns only while overlooking the current economic cycle the market is going through. Similarly, when investors lose money in a fund, they sometimes amplify their mistake by exiting at the bottom instead of holding on to investment for some more time until some of the losses are recouped.
So, in effect the behaviour of investors who strongly believe in consistency of returns can be blamed for this.
2. Well-diversified portfolio: The behaviour gap is lower in a well-diversified category of funds such as large cap funds. Investors usually invest in these funds because of their strong fundamentals and not because of any mad rush. So, the unique behaviour or trend is missing in these investments and thereby causing lower ‘behaviour gap’.
3. Higher bias in thematic funds: The returns in some thematic and sectoral funds are high but they don’t necessarily translate into higher returns for investors. The behaviour gap is more profound in sectoral and thematic funds. In thematic funds, they get a greater urge to exit during lows and enter during higher.
Sector funds are particularly prone to performance-chasing, with investors often piling into popular sectors after a strong showing and then bailing out when they fall out of favour.
“Since the pandemic in March 2020, categories like healthcare, technology, and global funds performed remarkably well when the markets rebounded. This, in turn, led to these categories receiving large amounts of flows as investors took notice,” states the report.
For the technology sector; the Investor Gap was highest at -24.78% per year over a 3-year period.
How to avoid them: The question, therefore, arises as to what should investors do to avoid biases of any kind. The age-old personal finance doctrines work well to curb these biases. At the outset, it is advisable to invest via systematic investment plans (SIPs) and avoid the mistakes committed while foraying into a fund at expensive valuations and exiting at lower.
Investing in a diversified fund is also better to improve the chances of earning higher returns. Investors, at the same time, should cut down their stake in thematic funds and keep it lower up to a maximum of 15-20 percent of total portfolio.